Hello and welcome to today’s podcast by Angel One.
Today we are discussing a very popular technical indicator.
Traders use a combination of both fundamental as well as technical analysis to understand price movements. And to understand why certain stocks perform compared to others. Indicators are an important aspect of technical analysis. Technical indicators are pattern-based signals that identify trading opportunities and can predict price behaviour.
One such indicator is the Spearman rank correlation. What is it?
Named after Charles Spearman, the mathematician who developed it, the Spearman rank correlation is a formula used to gauge the strength of the link between two datasets. The formula generates the Spearman coefficient which is used to assess the strength of a relationship between paired data, irrespective of the direction the chart takes. It can only be used in circumstances where data can be ordered, for example, in a descending or ascending order.
It can be a lot to process at once. Let’s approach it step-by-step.
For a better understanding of the Spearman coefficient, let us first decode what a ‘monotonic function’ means. A monotonic relationship can occur in paired data with 2 variable values, such as X and Y. If the values of X and Y rise together, or say if when X rises, Y falls: it can be considered monotonic even if the rate of their movements are not constant.
The values of the Spearman coefficient or rs ,(pronounced rho) falls between +1 to -1.
+1 value indicates a perfect strength between X and Y, meaning X rises the same amount with every unit of rise in Y. And a value of -1 shows a perfect negative strength, meaning X falls the same amount with a unit rise in Y. In both cases, X and Y are said to be perfect monotonic functions of each other.
A value of zero means there is no association between the movements of X and Y.
The Spearman coefficient is also understood clearly by learning about the Pearson coefficient.
It is similar to Spearman’s and is used to determine the strength of a linear relationship between two variables. In the Pearson coefficient, the variables increase at a constant rate. And while it can work with raw data, the Spearman coefficient works only with values that are rank-ordered.
This is important while considering when the Spearman rank correlation can be implemented.
When a scatterplot graph shows that the relationship of X and Y values might be linear or might be monotonic, it would be best to use Spearman’s.
Pearson coefficient will not work if data is not linear. On the other hand, Spearman coefficient will work if the relationship is monotonic -even if the data is not linear or perfectly linear.
That is the mathematics of it. But what role does Spearman indicator play in the stock market?
It has many applications in technical analysis and was popularised by the noted trader Dan Valcu. It helps assess the strength of a trend and of turning points. It can also be used to determine the correlation between a strong trend and the price changes.
The Spearman ratio is the ratio of the 2 datasets.
This number is multiplied by 100.
100 indicates a strength of correlation consistent with an uptrend.
Conversely, -100 associates with a strong downtrend correlation.
Typically the 2 variables used while applying the Spearman correlation in trading are: actual prices and an ordered list of that series. The correlation is often used to efficiently compare a security’s volatility to a price trend.
The Spearman rank correlation values above 80 could be an indication of tops or a positive trend. While values below -80 could be indicative of lows or a negative trend. Values of +100 or -100 are extreme and are not recorded often.
Spearman indicators can also be used to determine the levels at which you can place stop-loss or limit orders.
There is another term associated with trading, known as Oscillator indicators.
The Spearman indicator is one such oscillator. These indicators are significant in trading, as they help identify oversold or overbought conditions. An oscillator is a technical analysis tool that shows variations over a given period of time for a specific band. It comes in handy when the market is choppy and no specific trend is apparent. An oscillator like the Spearman indicator in the stock market makes for a clearer picture and provides buy or sell signals. It is typically used in a sideways market. It occurs when the price action oscillates across a horizontal channel.
Well that was a handful, wasn’t it?
Technical analysis always involves a range of tools. These tools help traders assess price movements and decide when to buy or sell. An oscillator that indicates any overbought or oversold market condition is very important. The Spearman indicator is a key tool that can be used with other tools for maximum accuracy. As we know that no technical tool or oscillator-indicator can function as a standalone tool for complete market analysis.
That was all about the Spearman indicator. Thanks for tuning in!